A Term You Should Know: Dollar Cost Averaging
One of the most common statements I hear from clients is that they wish they had learned more about personal finance somewhere in their educational experience. While it is a shame that financial literacy hasn't gained more traction in American schools, I'll leave my (very lengthy) thoughts about that for another post. I spent four years teaching personal finance to high school students and one of the concepts that I most enjoyed teaching about was dollar cost averaging. Now as a practicing financial planner, it's more than a concept, it's a habit.
Dollar cost averaging is the strategy of investing, usually a specific amount of money, on schedule regardless of what the market may be "telling you." It's tempting for not only DIY investors, but some professionals as well, to try to predict or time the markets about when they buy and sell securities. Like all areas of professional study, there is research that can support multiple positions, yet dollar cost averaging consistently continues to demonstrate long-term value.
Why does dollar cost averaging work?
1) Investing is best accomplished when emotions such as fear or excitement are not at play. Like in many areas of life, excessive emotional response is ineffective at yielding the best outcome. (Feel free to remind me of that next time one of my kids is making us late in the morning...again.) Investors tend to try to get out of the market after a day has gone poorly and into the market after a day has gone well. Such actions often turn out to be regrettable as they missed the proverbial boat.
2) Dollar cost averaging requires investors to fully accept that markets go up and markets go down and that it is not possible to reliably predict what the future will hold. The vast majority of professional money managers can't reliably make such predictions, which is why RVPF recommends and practices disciplined investment management that attempts to filter out the noise.
3) Investors seemingly have a need to tinker, especially when there is a lot of market volatility. It's very hard to sit back and do nothing, yet Jack Bogle, the founder and former CEO of Vanguard Group, is famous for saying "Don't do something, just stand there." Passive index investing with widely diversified, low-fee funds consistently outperforms a more active approach. According to a 2021 article published on Morningstar.com, dollar cost averaging outperformed actual investor performance by nearly 2% in international and domestic equities.
The one time that dollar cost averaging may not fit the bill is when an investor comes upon a lump sum of cash, often through an inheritance or employee bonus. Should they invest it all at once or over a period of time? In the long run, it's typically better to invest the lump sum all at once because you gain access to market returns sooner and because cash typically returns almost no interest. However, if you're prone to severe regret, it may be better to implement a disciplined dollar cost averaging strategy over a relatively short period of time such as once per week. It is worth mentioning that delaying the investment is in itself market timing.
I've seen it more times than I can count: a non-professional investor such as a friend, neighbor or colleague boasting about their expert stock picking. Believe me when I say that their recent successes are likely to be both a small slice of their story and unlikely to be replicated in the future. Additionally, a 2017 study by Fidelity showed that men conducted 55% more trades than women the year prior, which resulted in .4% lower annual returns than their female counterparts. Repeat this to yourself as many times as needed the next time your brother-in-law avails you of his investment stories. I apologize if it seems like I am picking on guys, but men more frequently fall victim to overconfidence bias when investing and their own ability to beat the market.
The moral of the story is simple: establish an investment plan that will occur on schedule in rain or shine because dollar cost averaging should be more than a term you know, it should be a strategy you know.
If you are looking for help with your investment strategy, reach out to Betsy at RVPF.